The Co-operative Bank's £1.5bn rescue package faced sharp criticism on Tuesday from bondholders who are accusing the City regulator of taking a punitive and arbitrary approach to the Manchester-based bank's capital requirements.

Bondholders facing losses have written to Andrew Bailey, the chief executive of the Prudential Regulation Authority (PRA), to warn that the bank could face nationalisation as result of the demands to raise fresh capital. They are also concerned about the damage being caused to the wider Co-operative Group, which includes pharmacies, funeral homes and grocers, and allege that a false market was created in the bank's bonds by the failure to disclose that the bank has needed to find extra capital since 2011.

Mark Taber, who fought a campaign against Bank of Ireland on behalf on bondholders, said 1,300 holders of Co-op bonds had contacted him after learning they were required to take losses to help find the extra capital. "Not only are the PRA's actions causing great distress, they also threaten to cause an avoidable standoff which could result in unnecessary nationalisation of the bank and massive damage to the Co-operative Group and mutual sector," Taber said in the letter copied to the new Bank of England governor Mark Carney and chancellor George Osborne.

The Co-op needs the support of bondholders for its plan to raise the extra capital. Co-op group is putting up £1bn to prop up the bank and bondholders will receive shares. The bank, currently a plc wholly-owned by the mutual group, will be listed on the stock exchange for the first time.

The Co-op took issue with an assertion by Tabor that the traditional hierarchy of capital structures was being ignored by requiring bondholders to take a loss before the shareholders were wiped out. The Co-op group insisted that its shareholding in the bank was being wiped out. "The group is therefore fully respecting the current capital hierarchy," Co-op said.

Many of the Co-op's bad loan losses stem from its takeover of Britannia Building Society in 2009 and Taber said the PRA's predecessor, the Financial Services Authority, had approved this deal.

Taber noted that Bailey had told the Treasury select committee that the regulators had known of the Co-op's capital position since 2011 but that this was never disclosed. He took issue with the government endorsing the now aborted deal to take over 631 Lloyds Banking Group group branches as a "virtuous model" for banks.

Taber also accused the PRA, which would not comment beyond acknowledging receipt the letter, of setting an "arbitrary" capital ratio, although the additional capital is thought to be needed to cover yet-to-be-revealed losses on loans. The Co-op Bank will reveal more about the terms of the so-called "bail-in" of bondholders after its results next month.

In a speech to the insurance industry on Tuesday, Bailey warned that insurers could be required to hold additional "add ons" of capital. The PRA is using what Bailey described as an early warning system to establish if the insurers will need to hold extra capital.